How Reserve Requirements Work ?

Reserve requirements are one of the most important features of modern central banking. We hear about reserve requirements almost every day in the media. When central banks like the Fed change these requirements, it is said to have a huge impact on the markets. Liquidity worth billions of dollars is said to be either released or sucked out from the system. But do we really know how reserve requirements work?

In this article, we will understand what reserve requirements really are and how they are implemented.

What are Reserve Requirements ?

The modern banking system is a fractional reserve banking system. This means that when the bank receives deposits, it is only required to maintain a certain percentage of these deposits in the form of cash on hand. The rest can be utilized to make loans.

Therefore, if the banks keep too much cash on hand, they are simply losing out on additional interest that could be earned by lending out that money. On the other hand, if they lend out too much and keep too little as reserves, there might be a possibility of a bank run and immediate insolvency of the bank. Earlier the decision regarding how much to hold in reserves was taken by the banks themselves. However, many of them were not good at estimating the reserve requirements and ended up landing in trouble.

In order to mitigate this problem, the central banks have started prescribing the required reserve requirements. It is now the legal responsibility of commercial banks to maintain the reserve requirements as prescribed by their central banks.

Another important point that needs to be noted is that reserve requirements are usually applicable only to demand deposits i.e. money in savings accounts, negotiable order of withdrawal (NOW) accounts, current accounts etc. In most countries around the world, reserve requirements are not applicable to time deposits i.e. money that is loaned out to the banks for a fixed period of time.

Example:

For instance, if a bank receives $500 as demand deposits and $200 as time deposits during the given period and the reserve requirement ratio is 10%. The reserve computation will be as follows:

Reserve Requirement on Demand Deposits = 10% of $500 = $50

Reserve Requirement on Time Deposits = 0% of $200 = $0

Total Reserve Requirements = $50

Reserves as Tools of Monetary Policy

Reserve requirements are remnants of an era gone by. The primary reason why reserves were required to be held was to prevent bank runs from happening. However, in the modern banking system, the Fed provides unlimited liquidity to its member banks in the event of a bank run. Thus, the banks have no real need to hold reserves since their solvency is guaranteed by the Fed.

In the modern times, reserve requirements have become more of a tool of monetary policy. This means that the central bank uses it to increase and decrease the amount of money supply in the system and therefore influence inflation. When central banks increase reserve requirements, the speed of credit creation is slowed down and liquidity is sucked out of the system. When they lower the reserve requirements, the opposite happens.

The purpose for which reserve requirements were held has undergone a drastic change. It is no longer a safety net against bank runs.

Viewing Reserve Requirements as a Tax

Many opponents of the reserve requirements policy have also viewed the regulation as an implicit tax that is imposed on the commercial banks by the central bank. This is because the central bank holds a certain percentage of their funds without paying any interest. The amount of interest lost as a result of this activity can therefore be viewed as a tax that has been imposed on the depository institution by the central bank.

The central banks across the world have never mentioned any intent to abolish the reserve requirement concept despite heated debates about the legitimacy of the same. They have however considered some proposals to modify the reserve requirements. They are as follows:

Graduated Reserve Requirements: Banks that accept more deposits from customers are typically at a larger risk of facing a bank run than smaller banks. As a result, some critics believe that central banks must create a reserve requirement structure which graduates with the quantum of the bank’s deposits rather than having the same rate apply to everyone. Thus, a graduated reserve requirement ratio would means that a certain percentage of the deposits will have to be held until a certain threshold is reached and then the percentage applicable becomes higher.

Logged Reserve Requirements: Logged reserve requirements were basically suggested to make it easier for the banks to calculate and manage their reserve requirements. At the moment, the reserve requirements are based on the current amount of deposits that a bank has. Since calculating the current deposits i.e. a dynamically changing number is difficult, managing reserve requirements also becomes difficult. The logged reserve requirement system suggests that the current week’s reserve requirements be calculated on the basis of deposits that were held two weeks earlier.

Evasion of Reserve Requirements

Commercial banks have been averse to reserve requirements ever since this regulation was created. They view it unnecessary blocking of capital without any compensation. It is for this reason that many of the products created by banks have been designed to minimize or completely evade reserve requirements. This is usually done by manipulating demand deposits to appear like time deposits or by charging processing fees along with loans being issued which cover the reserve requirements.

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